Federal Reserve
BankRoundtable on the Institutional
Structure of Financial Markets

Chicago,
Illinois
February 15, 2002

Carl
Sandburg gave us definition:

“Hog
Butcher for the World,

Tool
maker, Stacker of Wheat,

Player
with Railroads and the Nation’s Freight Handler;

Stormy,
husky, brawling,

City
of the Big Shoulders.”

And
this is how it evoloved:

In
the 60's we were called hustlers---

Bamboozling
the last dime from widows and orphans;

Proprietors
in a stacked game of corner the market;

And
yet we grew!

In
the 70's we were called arrogant impostors---

Pretending
to be relations to the holy temples of finance;

Stealing
the rightful markets of New York and London;

And
yet we grew!

In
the 80's we were called lucky---

Beneficiaries
of the inflationary aberrations of the 1970s;

Catering
to speculators, volatility and index arbitrage;

And
yet we grew!

In
the 90's we were called obsolete---

Archaic
mechanisms of a bygone era;

Inefficient
relics that could not compete with ECN technology;

And
yet we grew!

For
necessity had recast Sandburg’s definition:

Risk
Capital for the World,

Innovator,
Conceiver of Markets,

Player
with Concepts and the Nation’s Futures,

Stormy,
husky, brawling,

City
of the Big Shoulders.

Carl
Sandburg’s recast definition became our new heritage,
our new legacy. It brought us new fame, new image, new
industries, new jobs, new banks, new strength, a new future.
It protected us, rebuffing our competitors and rejecting
our antagonists decade after decade. But our legacy is
as tenuous as it is precious. Evolution is an unceasing
taskmaster and the imperatives of the twenty-first century
make new demands: modern technologies, demutualization,
efficiency. So the old question resurfaces: Can
we again meet the challenge of change and yet protect our
hard-earned franchise?

The
answer lies in understanding the three pillars of our legacy:
financial integrity, liquidity, and innovation. Lose any
one of them and you lose everything. It is a risky business.

Financial
Integrity

Let
me be blunt: Metaphorically speaking, Enron would
not have happened in Chicago. Neither would
Long Term Capital Markets, nor the most recent fiasco at
the Allied Irish Bank. Of course, I am referring to their
trading in over-the-counter (OTC) derivatives. For in the
structures of Chicago exchanges, or, for that matter, at
any centralized traditional exchange—whether in their
boisterous open-outcry pits or in the cyberspace of their
electronic screens—where trillions of dollars are
transacted daily then cleared and settled by their clearinghouses,
futures markets flourish within as safe a financial design
as the human mind can devise.

At
the core of these mechanisms lie some meticulously fashioned
and highly sophisticated operations. Mechanisms that represent
the very essence of their default-free success. Unlike
Enron—a darling of the so-called “New Economy”—the
combination of these interwoven components represent a
marvel of human thought and time-tested experience. Call
it the old-fashioned way, if you will. To be specific:

The
neutrality of their clearinghouses

Their
system of multilateral clearing and settlement

—providing
a central counterparty guarantee to every transaction

—eliminating
counterparty credit risk

Their
daily mark-to-market disciplines

—eliminating
accumulation of debt

Their
daily margining demands

Their
full disclosure standards

Their
transaction transparency

Their
audit trail regimen

Their
financial surveillance procedures

Their
regulatory requirements

I
have no hesitation in saying that these components epitomize
financial safety and transaction transparency—Enron
represented their opposite. Gretchen Morgenson of the New
York Times correctly called Enron “a master
of obfuscation.” Even more damning was Jerry Taylor,
the director of the Cato Institute:
“Enron,” he said, “was an enemy, not an ally, of free markets.
Enron was more interested in rigging the marketplace with rules and regulations
to advantage itself at the expense of competitors and consumers than in making
money the old fashioned way.” To put it another way, while Enron correctly
believed that energy could and should be traded like stocks, bonds, and futures,
it wanted to conduct its transactions in an opaque manner, devoid of disclosure,
conducive to conflicts of interest, and driven primarily by greed, ambition
and arrogance.

No
bilateral system, no matter the parties involved, can hope
to match the financial integrity and transparency of a
multilateral counterparty clearing facility composed of
the above-enumerated strictures—safer yet if the facility
is integrated with its trading engine so that at all times
it has the pulse of the entire marketplace. For instance,
at the Chicago Mercantile Exchange, the number-one U.S. futures
exchange, about $1.5 billion in settlement payments are made
daily. We manage $30 billion in collateral deposits. On September
17, we had pays and collects of $6 billion—without
a hiccup. Instead, Enron was a counterparty to every transaction
it executed—no trade intermediation occurred. In
other words, every trade on EnronOnline depended on Enron’s
creditworthiness. If you don’t understand what that
means, ask the people who are left holding the bag.

Liquidity

Let
me be brief: Without it there is no market. It
represents the constant flow of bids and offers to the
market, thereby liquefying the price-discovery process.
It allows every participant to assume or eliminate market
exposure quickly and at a fair cost. But liquidity is as
elusive as it is vital. Examples of failed systems by virtue
of a lack of liquidity are legion.

On
the other hand, “If you got it, flaunt it.” That
motto is nowhere more applicable than to the liquidity
at traditional futures exchanges. It is their hallmark—their
genetic code. While everything about them changed—while
detractors and demagogues accused them of everything from
the Black Plague to the 1987 Stock Crash, one thing remained
constant: Futures exchanges are by far the best in providing
liquid pools of buyers and sellers for the management of
risk. During world upheavals, this becomes their most coveted
asset.

Look
at the hundreds of millions of annual transactions at the
CBOE. Look at the CBOT’s 30-year bond contract with
its $23 billion in daily notional value or its note contract
averaging nearly $11 billion a day in turnover value. Look
at the NYMEX with its average daily volume of 466,000 contracts.
Look at the CME Eurodollar market. Consider, the average
daily volume in that instrument alone (futures and options)
is about 1,200,000 contracts, or $1.2 trillion every day.
And unlike at Enron, our traders never have to pretend
that they are busy.

Innovation

Let
me be explicit: If financial integrity is the heart of
our futures exchanges, if liquidity is the blood that flows
through its veins, then innovation is its soul—its
middle name.

Innovation,
the willingness to try something new, the genius to invent,
the nerve to confront what Milton Friedman calls the “Tyranny
of the Status Quo,” the audacity to take a risk,
the courage to fail is what separates the commonplace from
the phenomenal, the mundane from the divine, the past from
the future. In markets it is the difference between failure
and success. Without a soul, the market, like with every
human endeavor, will soon expire.

That
Chicago is the risk capital of the world is predominantly
the result of its middle name. Other market forums can
and have achieved financial integrity, other market arenas
can and have achieved liquidity, but what sets this city’s
futures markets apart from everyone else is an abundance
of all three components. Indeed, emulating the Chicago
Nobel laureate tradition of Milton Friedman, George J.
Stigler, Merton M. Miller, Gary Becker, Myron Scholes,
and a host of others, Chicago’s innovative soul is
quite unique. Beginning in the 1850s with the inauguration
of futures markets in the U.S., to the 1960s break from
storable products, to the 1970s revolutionary introduction
of financial instruments and the development of security
options contracts, to the 1980s debut of cash settlement
and the conceptualization of Globex, to the 1990s inception
of electronic mini-contracts, Chicago markets have consistently
been the incubator of innovation.

Indeed,
Chicago’s innovations in foreign exchange, interest
rates, security options, and equity index futures were
not only the model copied by every center of trade the
world over, it served as a mechanism that in the words
of Alan Greenspan “has undoubtedly improved
national productivity growth and standards of living.”

But
past accomplishments do not by themselves guarantee future
success. My fear is that in the process of modernizing
and demutualizing, which we must, we
neglect the principles on which we are founded—especially
our middle name. As we become like corporate America, as
we worry about quarterly results, as we concern ourselves
with shareholder values, as we rush to give our clients
what they seek, will our past continue to be prelude? Will
we remain the risk capital for the world? The innovator,
conceiver of markets? Or will we fail because
we forgot that our legacy depended not on
one or another of its embedded components but on all three?
There is a real and present danger that we become transaction
processing plants without a soul. It is a model with an
immediate allure, but one that spells eventual ruin.

As
our own history has proven, the inventor owns the market.
A postulate easy to grasp but very hard to achieve. It
is a goal that must resonate through every fiber of the
institution—a most ephemeral ambition. And,
lest we forget, the marrow of our past innovative success
has been our floor community. As we prepare
to meet current competition, as we evolve to become efficient,
can we preserve the resource they constitute? Can we retain
the intrinsic shareholder value they represent? While it
is certain that an electronic future is our destiny, have
we charted the correct course for its evolution? Let me
be clear: While it is mandatory to create the best electronic
system that can be devised, while we must advance its use
and effectiveness, the market, and only the market, can
dictate the timing of floor transference.

Innovation
is also costly and includes risk of failure. Failure is
counterproductive to the bottom line. Innovation is often
also counterintuitive to what clients seek. Indeed, clients
do not always know what they need. Were futures in foreign
exchange, or Eurodollars, or bonds invented because of
client demand? Were the energy contracts launched by the
NYMEX in response to a demand from the energy industry?
Not even close! By definition, innovation means to give
birth to something of which clients know nothing. It means
to prepare for contingencies not always visible. It means
to create new clientele. It means to predict what our clients
will need some day in the future.

The
Business of Risk

To
succeed, not only must we resist the temptation to serve
solely immediate demands, we must be wary of what our competition
wants us to become. There is a current philosophy in some
competitive quarters that exchanges and clearinghouses
should not be vertically integrated.
That they should be run as separate entities—and
operate as utilities. Were that to happen, it could prove
fatal.

Who
are these competitive quarters and what is their motivation?
Mostly they are large intermediaries. Their avowed purpose
in promoting the idea of transaction and clearing utilities
is to lower costs to their customers. It is no more than
a ruse. Werner Seifert, chair of Management Board of the
Deutsche Terminbörse AG, the world’s largest
futures exchange, calls it a “red herring.”
Seifert understands as we do that their real motivation is to
control their customers’ order flow. They want to
internalize their dealings, take the markets upstairs, and exploit
the profit from the bid/ask spreads. In doing so, they will
no doubt make lots of money, but there will be at least two fundamental
casualties in their wake.

The
first will be in the transparency implicit in the exchange-transaction
process, one that is vital to the world and its regulators.
Need we explain the inherent dangers in the loss of transparency
in financial transactions? Need we revisit the causes of
the Enron debacle? If you want a glimpse of where lack
of full disclosure can lead, you need look no further than
current reports of ambiguous accounting procedures—reaching
levels of abuse that often bordered on fraud. As a trio
of erudite Wall Street Journal reporters
(John R. Emshwiller, Anita Raghavan, and Jathon Sapsford)
recently pointed out, “Some of the world’s
leading banks and brokerage firms provided Enron with crucial
help in creating the intricate and misleading financial
structure that fueled the energy trader’s impressive
rise.” Forgive me for underscoring that some of these
same folks are the ones advocating that we become utilities,
and have organized their own exchange where the transaction
process has little if any transparency. Now, that’s
what I call Chutzpah!

The
second casualty will be that of innovation. Does anyone
here remember the last innovation produced by a utility?
Hardly, unless you count pre-demutualized futures exchanges—but
we were unusual under any definition. Again, Werner Seifert
states the proposition well:
“The entire value-added chain of securities processing from the initial
matching of trades and the determination of prices to the final steps in clearing
and settlement has to work with extremely high reliability....[O]nly vertically
integrated organizations can combine innovation with the level of reliability
that customers require.”

To
a degree, of course, this debate is an offshoot of the
ongoing competitive conflict between centralized exchanges
and ECNs. The fact that exchanges are regulated is only
part of the issue. Who provides the most efficient forum,
the highest liquidity, the best price at the cheapest cost,
are the critical considerations? Well, the winner of that
debate can be determined only by the ultimate arbiter—the
marketplace itself. And although the jury is still out,
there has already been some indication which way the verdict
is leaning. Countless of would-be-competitive ECNs that
were launched with great hoopla during the B2B bubble now
find themselves in the historical scrap heap. Indeed, long
before the terrorist attacks, there was growing recognition
by participants that centralized exchanges provided the
best combination of the ingredients necessary for safety
and liquidity—just check our volume statistics. Since
September 11, there is even less tolerance for experimentation. “Stick
with the tried and true” is the message we are hearing.
That theme is amplified—by an order of magnitude—with
the Enron experience.

So
call us hustlers or arrogant imposters; call us lucky or
even obsolete; call us what you like. We will remain the
risk capital for the world, the innovator and conceiver
of markets, so long as we remember the principles upon
which our legacy was built.